And it could come without warning this year if Beijing’s preferred gradualist approach doesn’t cool the red-hot economy
By VIKRAM KHANNA 25 January 2010
In recent days, Chinese policymakers have stepped up their efforts to cool China’s high-flying economy. But what we have seen so far could be only the beginning; there are likely to be more policy moves - including, possibly, some dramatic ones.
While there is debate about whether China’s economy is in bubble mode, few are in any doubt that it is overheating (neither are China’s policymakers themselves). There are many reasons for this, some unique to China, some not.
Together with other Asian economies, China has been one of the key targets of what economist Nouriel Roubini calls ‘the mother of all carry trades’. The carry trade is the phenomenon of speculators borrowing at a low interest rate and deploying the funds in higher-yielding assets, or currencies. They then enjoy the yield difference, or ‘carry’. Whereas the yen was the favourite borrowing currency pre-financial crisis, the US dollar has now taken its place.
China has pegged its currency to the US dollar (at about 6.8 yuan to the dollar since July 2008) partly to help its exporters in the face of the global crisis. But this peg means that China has to import America’s monetary policy and keep interest rates very low. If it tries to raise them, this would suck in more capital, thus making it harder to rein in domestic money growth. In order to prevent the yuan from rising in the face of huge capital inflows, China’s central bank has had to intervene in the forex market on a heroic scale, buying dollars and selling yuan.
In the process, last year alone, China added about US$450 billion to its reserves, which by year-end stood at close to a whopping US$2.4 trillion.
The counterpart of the reserve build-up has been the amount of money pumped into the domestic economy. Broad money growth in the last two months of 2009 was close to 30 per cent year-on-year - well above the official target of 17 per cent.
Bank lending has added to the problem. Last year, China’s banks lent a record 9.6 trillion yuan (US$1.4 trillion or S$2 trillion), one third more than in the previous year. Part of this was to finance China’s 4 trillion yuan fiscal stimulus package. But a lot of lending has eventually found its way into asset markets - mainly stocks and properties. The Chinese stock market jumped around 80 per cent last year. Property sales rose more than 75 per cent in 2009, while apartment prices in Shanghai and Beijing soared 50-60 per cent.
Dangerous
China is not well placed to be running such a loose monetary policy. Whereas the United States went through a severe credit crunch in 2009 and housing sector problems which warranted low interest rates, China did not. By importing America’s monetary policy, China has effectively turned the yuan itself into a ‘carry trade’ currency domestically, enabling locals to borrow cheap in pursuit of higher yields in the asset markets.
This is dangerous. The eternal China bull Jim Rogers has acknowledged that some of China’s real estate markets are in bubble territory. ‘Dubai times 1,000’ is how hedge fund investor James Chanos (who foresaw the collapse of Enron) characterises China’s situation. While there is hyperbole in this description, there is also an element of truth.
The potential danger is that China’s asset bubble will burst - and the consequences could be enormous. In essence, it will lead to massive losses for investors as well as Chinese banks, and could precipitate an asset price crash as well as currency problems across the region in an Asian crisis-style contagion.
As the property sector in China accounts for some 10 per cent of GDP and 20 per cent of total investment, the domestic consequences will be notable. Several sectors would be badly hit, including construction, steel, cement, and other capital goods industries - in which there is already overcapacity. In a snowballing effect, overall investment will drop sharply. The drop may not be short-lived: China’s past investment booms have taken several years to unwind. After the overheating of the early 1990s, for example, investment declined for seven years, from 44 per cent of GDP in 1994 to 36 per cent of GDP in 2001.
As investment declines, China will be hard pressed to boost consumption suddenly. The measures needed to do this - such as strengthening social safety nets and deepening financial reforms - cannot be effective overnight. With both investment and consumption slowing, China’s growth rate will take a hit, by some estimates as much as 3-4 percentage points. China’s banks will see their non-performing loans soar. And while the country has the means to deal with this problem, it could be an enormously costly fiscal exercise.
With its domestic economy facing problems, China’s dependence on the export sector will become even greater than it is now - at a time of weak global demand. This, coupled with the fact that hot money flows will reverse and start leaving China, will mean that the yuan will be under pressure to depreciate. As the overcapacity in China is being worked off, other Asian countries’ export sectors will all be hit and currencies regionwide will also come under downward pressure, in a contagion reminiscent of the Asian crisis.
Fortunately, China’s policymakers are wise to the dangers and have started to reverse some of China’s pro-overheating policies. But it appears that, given their gradualist mindset, they are trying to do this in calibrated fashion.
Starting on Jan 7, the People’s Bank of China (PBOC) started raising the cost of funding for lenders in the interbank market, by increasing the yields on three-month and one-year bills. From Jan 18, reserve requirements on Chinese banks were raised 50 basis points, effectively reducing their capacity to lend. This has been followed up with administrative measures to curb lending further.
Half-measures
However, these are not particularly aggressive moves; indeed, they are half-measures. For instance, administrative measures have in the past been easily circumvented - for example, by simply reclassifying projects. It is likely that more will be needed (and will be done) if China is to really start cooling down its red-hot economy.
One interesting proposal - made by, among several people, Barry Eichengreen of the University of California at Berkeley - is for China to substantially appreciate the yuan through a one-shot revaluation of 10-15 per cent. Other economists have proposed that in addition, China should let the yuan float within a fairly wide range against a basket of currencies. This would put paid to the expectations of yuan appreciation that are helping to drive capital flows into China. It would also give the PBOC more freedom to hike interest rates more aggressively to cool inflation and asset prices.
There would be some side effects; in particular, China’s export sector will suffer. But experts estimate that the impact will be limited. Zhang Bin of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, which advises the Cabinet, estimates that a 10 per cent revaluation would slow growth in export sales by 3.3 per cent.
On the plus side, a Chinese revaluation will shift more resources into the domestic sector and make China’s consumers richer, thus boosting domestic demand. It would accelerate China’s move into higher-value industries, at least in the coastal provinces where wages are relatively higher. A yuan appreciation would also help reduce global imbalances by reducing China’s trade surplus. If Asia’s currencies also appreciate in the yuan’s wake - a not unlikely scenario - this would further reduce global imbalances and help Asia become a more powerful engine of growth for the global economy.
As of now, China’s official policy remains to keep the yuan pegged at a more or less fixed rate to the US dollar, despite external pressure for greater flexibility. Chinese policymakers will do their best to keep this policy unchanged. Their preferred approach is clearly to try and control overheating through other, more gradualist means. But if those don’t work, watch for a without-warning hike of the yuan. It could happen in 2010.
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China’s tightening may end with yuan hike
And it could come without warning this year if Beijing’s preferred gradualist approach doesn’t cool the red-hot economy
By VIKRAM KHANNA
25 January 2010
In recent days, Chinese policymakers have stepped up their efforts to cool China’s high-flying economy. But what we have seen so far could be only the beginning; there are likely to be more policy moves - including, possibly, some dramatic ones.
While there is debate about whether China’s economy is in bubble mode, few are in any doubt that it is overheating (neither are China’s policymakers themselves). There are many reasons for this, some unique to China, some not.
Together with other Asian economies, China has been one of the key targets of what economist Nouriel Roubini calls ‘the mother of all carry trades’. The carry trade is the phenomenon of speculators borrowing at a low interest rate and deploying the funds in higher-yielding assets, or currencies. They then enjoy the yield difference, or ‘carry’. Whereas the yen was the favourite borrowing currency pre-financial crisis, the US dollar has now taken its place.
China has pegged its currency to the US dollar (at about 6.8 yuan to the dollar since July 2008) partly to help its exporters in the face of the global crisis. But this peg means that China has to import America’s monetary policy and keep interest rates very low. If it tries to raise them, this would suck in more capital, thus making it harder to rein in domestic money growth. In order to prevent the yuan from rising in the face of huge capital inflows, China’s central bank has had to intervene in the forex market on a heroic scale, buying dollars and selling yuan.
In the process, last year alone, China added about US$450 billion to its reserves, which by year-end stood at close to a whopping US$2.4 trillion.
The counterpart of the reserve build-up has been the amount of money pumped into the domestic economy. Broad money growth in the last two months of 2009 was close to 30 per cent year-on-year - well above the official target of 17 per cent.
Bank lending has added to the problem. Last year, China’s banks lent a record 9.6 trillion yuan (US$1.4 trillion or S$2 trillion), one third more than in the previous year. Part of this was to finance China’s 4 trillion yuan fiscal stimulus package. But a lot of lending has eventually found its way into asset markets - mainly stocks and properties. The Chinese stock market jumped around 80 per cent last year. Property sales rose more than 75 per cent in 2009, while apartment prices in Shanghai and Beijing soared 50-60 per cent.
Dangerous
China is not well placed to be running such a loose monetary policy. Whereas the United States went through a severe credit crunch in 2009 and housing sector problems which warranted low interest rates, China did not. By importing America’s monetary policy, China has effectively turned the yuan itself into a ‘carry trade’ currency domestically, enabling locals to borrow cheap in pursuit of higher yields in the asset markets.
This is dangerous. The eternal China bull Jim Rogers has acknowledged that some of China’s real estate markets are in bubble territory. ‘Dubai times 1,000’ is how hedge fund investor James Chanos (who foresaw the collapse of Enron) characterises China’s situation. While there is hyperbole in this description, there is also an element of truth.
The potential danger is that China’s asset bubble will burst - and the consequences could be enormous. In essence, it will lead to massive losses for investors as well as Chinese banks, and could precipitate an asset price crash as well as currency problems across the region in an Asian crisis-style contagion.
As the property sector in China accounts for some 10 per cent of GDP and 20 per cent of total investment, the domestic consequences will be notable. Several sectors would be badly hit, including construction, steel, cement, and other capital goods industries - in which there is already overcapacity. In a snowballing effect, overall investment will drop sharply. The drop may not be short-lived: China’s past investment booms have taken several years to unwind. After the overheating of the early 1990s, for example, investment declined for seven years, from 44 per cent of GDP in 1994 to 36 per cent of GDP in 2001.
As investment declines, China will be hard pressed to boost consumption suddenly. The measures needed to do this - such as strengthening social safety nets and deepening financial reforms - cannot be effective overnight. With both investment and consumption slowing, China’s growth rate will take a hit, by some estimates as much as 3-4 percentage points. China’s banks will see their non-performing loans soar. And while the country has the means to deal with this problem, it could be an enormously costly fiscal exercise.
With its domestic economy facing problems, China’s dependence on the export sector will become even greater than it is now - at a time of weak global demand. This, coupled with the fact that hot money flows will reverse and start leaving China, will mean that the yuan will be under pressure to depreciate. As the overcapacity in China is being worked off, other Asian countries’ export sectors will all be hit and currencies regionwide will also come under downward pressure, in a contagion reminiscent of the Asian crisis.
Fortunately, China’s policymakers are wise to the dangers and have started to reverse some of China’s pro-overheating policies. But it appears that, given their gradualist mindset, they are trying to do this in calibrated fashion.
Starting on Jan 7, the People’s Bank of China (PBOC) started raising the cost of funding for lenders in the interbank market, by increasing the yields on three-month and one-year bills. From Jan 18, reserve requirements on Chinese banks were raised 50 basis points, effectively reducing their capacity to lend. This has been followed up with administrative measures to curb lending further.
Half-measures
However, these are not particularly aggressive moves; indeed, they are half-measures. For instance, administrative measures have in the past been easily circumvented - for example, by simply reclassifying projects. It is likely that more will be needed (and will be done) if China is to really start cooling down its red-hot economy.
One interesting proposal - made by, among several people, Barry Eichengreen of the University of California at Berkeley - is for China to substantially appreciate the yuan through a one-shot revaluation of 10-15 per cent. Other economists have proposed that in addition, China should let the yuan float within a fairly wide range against a basket of currencies. This would put paid to the expectations of yuan appreciation that are helping to drive capital flows into China. It would also give the PBOC more freedom to hike interest rates more aggressively to cool inflation and asset prices.
There would be some side effects; in particular, China’s export sector will suffer. But experts estimate that the impact will be limited. Zhang Bin of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, which advises the Cabinet, estimates that a 10 per cent revaluation would slow growth in export sales by 3.3 per cent.
On the plus side, a Chinese revaluation will shift more resources into the domestic sector and make China’s consumers richer, thus boosting domestic demand. It would accelerate China’s move into higher-value industries, at least in the coastal provinces where wages are relatively higher. A yuan appreciation would also help reduce global imbalances by reducing China’s trade surplus. If Asia’s currencies also appreciate in the yuan’s wake - a not unlikely scenario - this would further reduce global imbalances and help Asia become a more powerful engine of growth for the global economy.
As of now, China’s official policy remains to keep the yuan pegged at a more or less fixed rate to the US dollar, despite external pressure for greater flexibility. Chinese policymakers will do their best to keep this policy unchanged. Their preferred approach is clearly to try and control overheating through other, more gradualist means. But if those don’t work, watch for a without-warning hike of the yuan. It could happen in 2010.
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